Credit and the Curious Lack of Money in the Economy (According to Ray Dalio)

A major difference between cash and credit is that when you settle a transaction in cash, it is settled immediately.  When you settle it with credit, you are “starting a tab.” Each such transaction creates both an asset and a liability.  The asset and the liability remain until you pay off the debt and the transaction is settled.

The shocking truth is that what most people consider money is in truth credit. The total amount of credit in the United States today is somewhere in the neighborhood of $50 Trillion, while the amount of actual money is only about $3 Trillion.  Economies with credit can “heat up” quicker than hypothetical economies without it, but the boom times cannot last because, at some point, the debt must be repaid.

So is credit merely an evil that causes painful economic cycles?  Not necessarily. It is evil when it fosters overconsumption that borrowers can’t pay back.  It can be a good thing when it efficiently allocates resources. This usually happens when people intelligently use credit to increase productivity.  It is especially valuable when it increases productivity driven income above the amount borrowed, which leaves the borrower in a better position despite having to pay off the debt.  Buying an awesome new 65-inch television on your credit card is stupid because it doesn’t generate income to help you pay back the debt. The bottom line is that credit is only good when it helps you make more money than the credit costs.  Borrowing money from your parents to take a college class that gets you a raise at work is an excellent example (assuming that Mom isn’t charging you too much interest).

The result of all of these increases in spending and paying back debt, we eventually reach an inflection point.  An inflection point is a point (usually on a graph) where the trend reverses and starts to go the other way. This is what causes the short-term debt cycle.  The early spending (largely on credit) phase is usually referred to as an (economic) expansion.  During this time, spending continues to increase, and prices start to rise because the supply of money and credit outstrip the production of goods.   We pay more to get what we want now.  

When prices rise like this, we call it inflation.  The central bank likes a little inflation (say around 2%), but they will take action if it gets much higher than that because high inflation generates problems.  The most common way to deal with rising inflation is to raise interest rates; the higher rates make money more expensive to borrow, and the credit cycle slows down. You can think of this as being like the monthly payments on your credit cards going up.  You can’t afford to borrow any more money because it is more expensive to pay for what you already borrowed. The lack of cash (it’s going to pay off debt) and the lack of credit (you’re already extended) means that spending slows down.

When spending slows down, none of the people that you were buying stuff from are making as much money, so, in turn, their spending slows down.  In this way, the interest rate can be used by the Federal Reserve as a thermostat for the entire economy. When people are spending less is that prices go down, which is called deflation.  Economic activity decreases across the board and we have a recession.  If the recession gets too severe and inflation isn’t a problem, the central bank will lower interest rates and cause the economy to pick up again.  

This works because with low-interest rates, debt is reduced.  The cost of borrowing money is cheaper, and people and businesses are more likely to borrow.  That borrowing results in increased spending, and the cycle starts all over again. We see another expansion.  We can talk about these effects in terms of credit availability. When credit is easily available, there is an economic expansion.  When credit is not easily available, there is a recession. Whichever way the economy is moving, the central bank usually has a hand in it.  These short-term cycles tend to last from five to eight years, and they happen over and over again for decades.

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Credit and Economic Cycles (According to Ray Dalio)

This is the fourth post in my series on Mr. Ray Dalio’s remarkable little film How the Economic Machine Works.  I suggest you read those before beginning this one.  In this post, we will follow along with Mr. Dalio and examine the interaction between productivity and credit, and how that interaction plays into economic cycles.

According to Mr. Dalio, the proximate cause of economic swings is credit.  Credit allows us to spend more than we produce as soon as we get it.  When we start to pay it back, it forces us to spend less than we consume.  This superimposes an S-shaped curve over the nice, smooth line of productivity.  While we are spending credit, we are above the line of our productivity; when we are paying the loan back, we are spending below our productivity line.   According to Mr. Dalio, we can expect two different types of debt cycles. The short one takes from five to eight years, and the (much) longer one takes between 75 and 100 years.  

These are cycles, but often we don’t see them that way because we aren’t considering the spans of time involved.  When I can’t afford to pay my bills, I’m not considering how my behavior five years ago led me to my current predicament.  When we only view them from day to day or week to week, they just look like “booms” and “busts” and their cyclicality is hidden. It is important to note that swings around the line are not due to how much innovation or hard work there is.  The slope of the productivity line may be affected by massive amounts of innovation and hard work over a long period of time, but rapid swings are almost always the product of credit cycles. In other words, whipsaw action in economic conditions is most often a direct effect of how much credit there is.

In an economy without credit, the only way to grow is to increase your productivity.  You can learn more, innovate more, and work harder, but you can’t borrow money in such an economy.  An economy like this would be very flat on our graph. There would be an almost imperceptible move forward, and we would see it as if it were standing still. In other words, there would be no cycles.

In the real economy, as a natural result of our collective borrowing behavior, we have cycles.  You can’t blame Congress for this one. The lawmakers don’t cause economic downturns more than they do economic upturns (Sorry, Mr. President).  Cycles in the economy are caused by credit, and credit works the way it does because of human nature and the system we have in place to facilitate that credit.

Borrowing has the effect of pulling earnings forward.  To buy something you can’t afford, you must spend more than you make.  You must borrow productivity from your future self. Your poor future self must spend less than is produced in order to pay back the debt.  Therefore, when you spend what you make, the spending curve is “flat.” When you spend more than you make (use credit) your spending is in an uptrend.  When you must start paying back the borrowed money, your spending goes into a downtrend. Because you spending effects the income of everyone connected to you in the money chain, their income drops are your spending drops.  By definition, a cycle is formed. Anytime you borrow, you create a cycle. This is just as true for overall economies as it is for individuals. If follows that as long as there is credit in the economy, there will be economic cycles.

If all of this sounds rather mechanical, that’s because it is.  That’s why Mr. Dalio called it the “economic machine.” According to him, it also means that these cycles are predictable.  

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Productivity, Credit, and the Economy (According to Ray Dalio)

This is third post relating to Ray Dalio’s remarkable little video, How the Economic Machine Works (link at the bottom of this page).  In this one, we will consider the relationship between economic productivity and credit, and how that affects the overall economy.

As Mr. Dalio explains,  credit is important to the economy because when borrowers receive credit, they can increase their spending.  Spending, you will recall, is what drives the economy. Because of the nature of transactions, one person’s spending is always another person’s (or entity’s) income.   This makes perfect sense.  Every dollar that you spend, someone else earns.  Every dollar that you earn resulted from someone else spending.  Economies consist of transactions, and those transactions tend to form long chains that depend on the preceding transaction to go forward.  This means that when you spend more, someone else earns more.

When someone’s income rises, it makes lenders more willing to extend him or her credit.  The person has more money coming in, so it is more likely that the person can pay down more debt.  In other words, the person is more creditworthy. Creditworthiness is a big deal in our modern economy, and we use credit scores to determine the creditworthiness of individuals.   To be truly worthy of credit, you need the ability to repay (a good income) and collateral.  Collateral is something of value that you can sell to meet your obligations if you find in the future that your income is insufficient.  When you buy a car or a house, for example, the thing you bought is the collateral. If you don’t pay your car loan, the bank will repossess it.  

More income means that people can spend more, but it also means that they can borrow more.  More credit leads to more spending. This, too, happens in a chain reaction. If my spending goes up, then the people that I buy stuff from also see an increase in income.  This means that they have more money and more credit, so their spending will go up. The pattern is self-reinforcing, and it leads to economic growth. That sounds great, but the problem is that it leads to economic cycles.  

In a normal transaction, you have to give something to get something.  How much you get is determined by how much you produce.  Over time, we learn and innovate, and that accumulated knowledge raises our living standard (because we can make more money).  This tends to happen across the board, and we call such an increase productivity growth.   Those that are inventive and hardworking can raise their standard of living quickly.  If you are complacent and lazy, then the opposite will be true.

Often, we don’t see that fact because productivity matters most in the long run.  In the short run, credit can make up for a lack of productivity. In practice, we can’t really tell if spending increases are caused by more productivity or more credit.  A major factor in this timing issue is the fact that productivity tends to be slow and steady over time. This means that productivity growth is seldom a major factor in economic swings.  On the graph we talked about earlier, there tends to be a straight line with a slight upward slope, representing the idea that productivity grows slowly but steadily over time.

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The Role Of Credit In The Economy (According to Ray Dalio)

In a previous post, I summarized Ray Dalio’s take on how the “Economic Machine” works.  In this article, we will consider the role fo credit within that economy.

If we add up the total money spent and the total credit spent, we will know the total spending.   This is important because the total amount of spending is what drives the economy.  Transactions, then, are the atoms that make up the economic machine. These powerful substances drive all economic forces and cycles.  If that makes good sense, then you will be in good shape. If you can understand transactions, says Mr. Dalio, you can understand the whole economy.

A market is made up of all the buyers and sellers making transactions for the same type of things.  We hear this term in finance often; there are stock markets, bond markets, and commodity markets.  The idea is no different than the idea of a “supermarket” where you buy groceries, or a “flea market” where you buy antiques and such.  

An economy, then, consists of all of the transactions in all of its markets.  It is important to note that while many transactions are between individuals, transactions occur between businesses, banks, governments, and a host of other organizations.  If a person or an entity engages in transactions, then we must include it in our consideration of the economy. In fact, the absolute biggest buyer and seller is the government.  At the national level, the idea of “government” consists of two important parts. There is the central government that collects taxes and spends money.   Also of great importance to the economy is the central bank.  In the United States, the central bank is called the Federal Reserve.  The Federal Reserve is different than other market participants (buyers and sellers) because it controls the amount of money and credit in the economy.

The Federal Reserve can do this because it has the power to set interest rates, and it has the power to print money.   This makes the central bank a key player in the flow of credit. According to Mr. Dalio, credit is the most important and least understood part of the economy.  This importance comes from the fact that it is at once the biggest and most volatile part.

If we think about how credit works, it consists of lenders and borrowers making transactions in a credit market.  Lenders are usually those that have excess money, and they want to make that money grow. Borrowers, on the other hand, usually want to buy something that they can’t afford.  Think about how integrated this idea is in our society. Who do you know that has purchased a house or a car without using credit? Some (more responsible) people also borrow money to start or expand a business.  Despite my assertions to the contrary, credit isn’t totally evil. It can help both lenders and borrowers get what they want.

The nature of credit, then, involves a borrower promising to repay what they borrowed (the principal) and pay an additional amount known as interest.  When interest rates are high, there is less borrowing because borrowing, under those circumstances, is expensive.  When interest rates are low, borrowing tends to increase because it is cheaper. All that is necessary to create credit is that a borrower is willing to make a promise to repay and a lender is willing to believe the borrower.  This means that any two parties can agree to create credit out of thin air. This is all really pretty simple, but we complicate it by giving it a bunch of different names. As soon as two parties create credit, it immediately turns into something called debt.  Debt is considered an asset by the lender, and a liability to the borrower.  

When the agreed upon date arrives and the borrower pays back the loan with interest, the debt disappears (back into the thin air from which it came) and the transaction is said to be settled.  

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